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Commentary
Blame Wall Street
Martin T. Sosnoff 01.24.08, 6:00 PM ET
Martin Sosnoff
They say the beer tastes better when you're poor, but don't believe it. We are indebted to Ben Bernanke for dropping the fed funds rate 75 basis points considering the mini panic in foreign securities markets. I'd like to see 3% tout de suite, and it's heading there.
Where is Congress and the president? Still in left field. Priming equivalent to 1% of gross domestic product (GDP) is too feeble. Not even our presidential candidates are pressing for more, but what do they know about Keynesian theory? We could use a $300 billion injection considering the prospective slough-off in consumer spending I see coming. Even that much doesn't compensate for the middle class's shrinkage in net worth of $6 trillion.
Wall Street not only shot itself in both feet, destabilized credit markets and topped out the stock market, but it dented the wealth of the country sufficiently to impact consumer spending by a couple of percentage points for a year or longer. We the people share the blame by overspending and under saving for years and years.
When the pundits and academics finish analyzing this recession you can bet they will point to more than a decade-long binge of debt creation in the private sector. But the palm goes to Wall Street and our reserve city banks for destabilizing the home construction sector, normally over 5% of GDP, currently nearing 4%.
Why should we care that a small sector of GDP got crunched? Well it topped out home valuations everywhere and so far lopped 10% off the stock market. Family wealth is evenly split between real estate and financial assets. It stood at $60 trillion a year ago, now mid-50s, maybe headed to $50 trillion if you take another 10% off homes and the stock market--not so far-fetched.
In the heady leveraged buy out days of the mid-80s, I asked Mike Milken why he packaged so many iffy deals. "Look," he said, "I'm like a movie producer. You work on a deal, finish it and move on to the next one. You never look back." This mindset sums up Wall Street's attitude to all its underwriting of below-investment grade paper the past few years.
Sometimes you get caught with unmoveable sardines, and they spoil overnight. Drexel Burnham financed its junk bond inventory with short-term borrowing and destroyed itself when interest rates soared. Nobody cared, because Drexel's demise carried with it no macro consequences. The Street gloated openly.
What bothers me is not homebuilding, which can only contract GDP by another 0.5%. Rather, any recovery from this malaise could be saucer shallow, keeping the country from hitting its stride of normalized GDP growth of 3.5% for a year or longer.
Some good things are happening. Interest rates are headed lower for prime borrowers. The London Inter-bank rate, the bench mark for adjustable rate mortgages, has dropped almost a full percentage point, now on parity with our new fed funds rate.
The liquidity crisis for our banks is receding. I can see fed funds at 3% soon. The cost to carry all kinds of debt works lower. Petrodollars and the Chinese have refueled Wall Street just enough to keep their prime credit ratings, but Merril Lynch's (nyse: MER - news - people ) and Citigroup's (nyse: C - news - people ) equity stands diluted by 20%.
So why is the market so farmisht (confused)? The Standard & Poor's 500 Index broke below the 1,350 level I thought was fair--value, 15 times flattish earnings this year. I may have the multiplier right but maybe my earnings estimate, $90 a share on the S&P 500, below consensus, is too generous.
I dove back into my S&P earning model sector by sector. Even after adjusting for lower technology growth, lopping 10% off the energy sector, flattening financials and reducing capital equipment, I still came up with $90 and change. I stand by 1,350 as fair value for the market in the context of low interest rates, but my model projects just a mild cutback in consumer spending.
When I lived in a bedroom community in Connecticut in the 1970s and 1980s, a plain vanilla colonial, white washed with green shutters, in four-acre zoning sold for $200,000. Twenty years later it became a $2 million property. That's why consumer spending rose from 66% of GDP to 71%. Everyone spent some unrealized gains.
We've had a long cycle of asset accretion, overspending and debt creation. You can't correct this overnight. Home prices won't reverse so fast because rentals remain competitive with home ownership. Eventually, secular forces take over. Family formations run over 1 million per annum, and home ownership remains an embedded goal for young marrieds.
How do you correct long cycle excesses? Little by little. Economic recovery is pushed out to 2009 with a saucer-shaped rather than V-shaped chart. Not the best scenario for a zippy stock market. There are some pluses. Hundred-dollar oil is old news. We're under $90, headed towards $80 and the dollar shows stability of late.
After processing all the short- and long-cycle phenomenon, my best guess is the stock market bottoms out sequentially, sector by sector. Most brokerage stocks are down to 1.5 times book value, their historic intrinsic valuation, and they're hanging on. The energy sector with costs rising 10% or more is vulnerable to down earnings. Health care is OK because it's non cyclical and reasonably priced. Tech is mixed, vulnerable to consumer weakness and Wall Street pulling in its capital spending.
Can the high-voltage properties sustain their momentum? If they don't disappoint, tech is viable, not overpriced like 1999 and 2000. Apple's (nasdaq: AAPL - news - people ) quarter blasted through the consensus numbers, but anything tied to the consumer is suspicious for at least a few quarters. Meanwhile, non-cyclicals like Coca- Cola (nyse: KO - news - people ) and Procter & Gamble (nyse: PG - news - people ) look fully valued and toppy.
Airlines are instructive. They bottomed on intrinsic value, not on earnings, but their sizable liquid assets. Could we see a Buffett-style market where intrinsic value players take over from momentum hot shots? Maybe. Warren's still buying railroads whose contract rates are turning over higher this year. I own Union Pacific.
In the early 1960s, Khrushchev vowed Russia would bury Disneyland. Nobody buries Disneyland. The country retains great resiliency, but it may take a while before it kicks in. We won the Cold War because our GDP growth rate outstripped the Soviet's. They couldn't keep up with our budget allocations to defense spending.
All our policy initiatives today need to concentrate on restoring GDP momentum. Buying stocks on normalized earnings projections is the new gamesmanship for many managers. Let's hope our timing is right. I just bought more AT&T (nyse: T - news - people ) and IBM (nyse: IBM - news - people ).
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